DUBAI, Aug 5 (Reuters) - Omar Ibn al-Khattab, ruler of a nascent Islamic empire in the seventh century, once convened a meeting in Medina to admonish his subjects "for avoiding trading and leaving the markets in the hands of the foreign traders".

The story underscores the importance given by Islam to real economic activity, said Muhammad Qaseem, head of the sharia department at Dubai Islamic Bank-Pakistan. "One of the main sources of earning pure wealth is true sharia-compliant trade."

Centuries later, however, the Islamic finance industry - which is growing rapidly in some areas, such as debt issuance - is neglecting merchandise trade, leaving trade finance for conventional banks to dominate.

When the Paris-based International Chamber of Commerce held its regional meeting in Qatar in March, for example, a five-day agenda devoted just 30 minutes to Islamic finance.

The event brought together trade experts from around the globe, but Islamic banks were not prominent. In contrast, Commercial Bank of Qatar and Qatar National Bank , both conventional lenders, were major backers of and participants in the event.

Both the Morocco-based Islamic Centre for Development of Trade (ICDT) and the International Islamic Trade Finance Corp (ITFC) have called for "capacity building" activities such as seminars and workshops to spur trade among Muslim countries, but such efforts remain largely unmatched by Islamic banks.

"I have not seen a dedicated forum for Islamic trade finance. There are some attempts...but they are not focused," Nazeem Noordali, general manager of corporate and structured finance at the ITFC. "I don't know how ready they are."

Educational efforts by Islamic finance bodies are "not doing well", said Arif Khalifa, head of global trade finance at Kuwait Finance House. "They are only focusing on introduction and definitions...Conventional banks are more developed."

The Saudi-based ITFC, a non-government entity promoting Islamic trade, approved transactions worth $3 billion in 2011, 29 percent of which came from the Middle East and North Africa.

YOUTH

One problem lies in the relative youth of Islamic banks, many of which have only had major international operations for a decade or so and which do not have large numbers of experienced staff with technical expertise in trade.

Conventional banks, on the other hand, use trade finance to win more business from clients across the whole supply chain, said Alam, a former head of Islamic structuring at JP Morgan.

"If Islamic banks want to take it seriously, they need to go through that intellectual hurdle."

At present, Islamic banks' preference is for straightforward lending products, Alam said. "Islamic banks want financing to be as simple as possible; all they know is debt financing - who and how much. It all ties up into their cost-benefit analysis."

Islamic banks could address their limited size through outsourcing, he added. "They can ask conventional banks for help in execution, operation...The big trade finance banks will educate you."

TRENDS

In fact, global trends promise to increase the scope for Islamic banks to expand in trade finance.

Trade between the Organisation of Islamic Cooperation (OIC), which has 57 member countries, and the rest of the world reached $1.59 trillion in 2010, representing 10.5 percent of the world's total, according to the ICDT. Countries with the highest increase in trade volumes last year included Bangladesh, Nigeria and Indonesia, it said.

"There is an opportunity for Islamic banks to be more involved in trade flows between Africa and the rest of the world," said Noordali.

Meanwhile, the euro zone debt crisis is forcing European banks, leaders in trade finance, to retrench. This is leaving an opening for others, John Ahearn, managing director and global head of trade for Citibank, said in an ICC report.

But that window of opportunity may close as non-European conventional banks strengthen client relationships and realign strategies. Conventional banks in the Gulf such as National Bank of Fujairah aim to expand in the field; "business is picking up, other banks are eyeing the sector," said R S Rangan, head of trade services at NBF.

Another factor which may ultimately aid Islamic banks is the phasing in of Basel III banking standards around the world over the next several years.

This could make trade finance more expensive by requiring banks to increase capital reserves. But because Islamic banks in general already adhere to stricter capital requirements, they will face less of an increase in costs, said David Vicary, chief executive of the Malaysia-based International Centre for Education in Islamic Finance.

Islamic transactions tend to be on-balance sheet, so banks must hold more capital reserves; conventional banks have been keeping more transactions off-balance sheet but won't be able to do this as much under Basel III.

"Stronger and better Islamic banks will take Basel III as an opportunity to strengthen their competitive positions," Vicary said.

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